FINANCIAL STRUCTURE OF THE FIRM Chapter 16

MAIN CONTENTS
• Internal versus external financing
• Equity and debt financing
• The irrelevance of capital structure in a frictionless environment
• Why choosing optimal capital structure? (reducing costs, dealing with conflicts,
creating value for stakeholders)
• How to evaluate levered investments
FRICTION VERSUS FRICTIONLESS FINANCIAL ENVIRONMENT

• Friction: Contract law, taxes, other regulations which make capital structure matter
In practice: all these above factors differ from place to place and change over time.
Hence, (1) there is no single optimal financing mix (raising funds from debt, equity and
other financial instruments) that applied to all firms, and (2) in analyzing optimal
capital structure of a firm, financial manager is required to trade-off that depends on
the particular legal and tax environment. The value of the firm is affected by the way
that financial manager decides the financing mix
• Frictionless: No taxes, no transaction costs, it is costless to make and enforce. The
value of the firm is not affected by its financing mix
INTERNAL VERSUS EXTERNAL FINANCING

• Internal financing: arises from the operation of the firm, that includes retained
earnings, accrued wages, or accounts payable. The firms will use these types of
money for the next period
• External financing: arises from outside lenders or investors (debt, equity, other
financial instruments)
• Normally, it takes more time and efforts to make external financing. However, for a
well-established firms and need for huge funds, financing decisions are routine,
automatic and often involves external funds. In addition, external financing are more
subject to discipline of the capital market rather than internal funds
EQUITY FINANCING

• Equity is a claim to the residual that is left over after all debts have been paid
• There are three types of equity financing: common stock (shares), stock options,
preferred stock
• For common stocks: Classes of common stocks differ depending on its voting rights
and the ability of the holder to sell them to other parities
• Restricted stocks: issued to the founders of the corporation, cannot be sell before a
certain time
• Stock options: give the holder the right to buy common stock at a fixed exercise
price in the future. The holder of stock options can convert them into common stock
EQUITY FINANCING

• Preferred stocks: corresponds to a specified dividend that must be paid before

common stocks holders
• However, one unfavorable point is that preferred stocks holders will receive only
promised dividends, without any shares from residual value of the firms
• For firms, failure to pay preferred dividends does not signal a default
DEBT FINANCING

• Debt is a contractual obligation on the part of the corporation to make promised

future payments in return for the resources provided to it
• Debt financing includes loans and debt securities. Debt securities consists ò bonds,
mortgages accounts payables, leases, and pensions
• For many corporations, long-term lease and pension liabilities may be much larger
than the amount of debt in the form of loans, bonds, and mortgages
DEBT FINANCING- SECURED DEBT

• When firms borrow money, it promises to pay regular payments to creditors

• To secure for that promises, the firms pledge a particular asset (called collateral)
and the debt is called secured
• In the event of nonpayment, the secured lender will subject first to those assets (may
be one asset or more than one asset) while the unsecured lenders will not (even may
not paid anything)
DEBT FINANCING- LONG TERM LEASES

• Leasing an asset for a long time (long term means that this leasing covers much of
the asset’s useful life) is identical to buying the asset and financing the purchase with
debt secured by the leased asset. In other words, you are 2 options that are
equivalent: leasing asset or buying it, the asset to be leased in the former is exactly
the asset wants to be bought in the latter. However, in the latter case, you may issue
bonds that are secured by the same asset as in the case of leasing
• The main difference between two options is that: for a case of buying from a
secured debt, a firms bear the risks. Meanwhile, for a case of leasing, the lessor (the
firm that has leased asset) will bear the risks the residual-value risks (the value at the
end of the lease term)
DEBT FINANCING- PENSION LIABILITIES

• You should recall from chapter 2: What is a pension plan?

• Remember: two types of pension plans: defined contribution and defined benefit
For defined contribution: employee makes regular contribution (through employee’s
account). At the time of retirement, they will receive a benefit that depends on the
accumulated value of the funds in employee’s account
For defined benefit: the benefits that each employee receives depending on seniority,
in most cases, that are wages or salaries
• For corporations with defined benefits, promises to pay future benefits are a
significant part of the firm’s long term liabilities. And this classification also depends
on the laws of each country in corporate practices, and in turn, decides different
corporate capital structure
THE IRRELEVANCE OF CAPITAL STRUCTURE IN A
FRICTIONLESS ENVIRONMENT
• There has lots of different ways for choosing possible capital structures, so,
why does one firm prefer one to another?
• Modigliani and Mille (M&M) showed that in a world of frictionless market, the
total market value of all the securities issued by firm would be governed by
the earning power and risk of its underlying assets and would be independent
of how the mix of securities issued to finance it was divided.
• Or in other words, the total market value of the firm is independent of its
capital structure
THE IRRELEVANCE OF CAPITAL STRUCTURE IN A
FRICTIONLESS ENVIRONMENT
• M&M’s frictionless environment assumes the following conditions
•No income taxes
•No transactions cost of issuing debt or equity securities
•Investors can borrow on the same terms as the firm
• The various stakeholders of the firm are able to costlessly resolve any
conflicts of interest among themselves
THE IRRELEVANCE OF CAPITAL STRUCTURE IN A
FRICTIONLESS ENVIRONMENT
• Suppose two firms with identical assets. They only differ in their capital structure
• Firm A issues only stocks, firm B issue debt and stock
About firm A:
• Firm A with EBIT $10 million per year and this amount of money is used to pay all as
dividends. If the market capitalization rate is 10%, the current total market value of
$10 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
firm A is = $100 million (is equivalent with calculating the PV of perpetuity
10%
for a cash flow of $10 million
• With outstanding 1 million shares of common stocks, the price per share is
$100 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 (𝑡ℎ𝑒 𝑡𝑜𝑡𝑎𝑙 𝑚𝑎𝑟𝑘𝑒𝑡 𝑣𝑎𝑙𝑢𝑒)
= $100
1 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 (𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑠ℎ𝑎𝑟𝑒𝑠 𝑜𝑢𝑡𝑠𝑡𝑎𝑛𝑖𝑛𝑔)
THE IRRELEVANCE OF CAPITAL STRUCTURE IN A
FRICTIONLESS ENVIRONMENT
About firm B: (firm B is identical to firm A in its investment and operating polices,
hence, firm B has the same EBIT expected value and risk characteristics as firm A)
• Firm B issues bond that have a face value of $40 million at an interest rate of 8%
per year (assumes the bonds are in perpetuity, default risk and the riskless rate of
interest is 8% per year)
• Coupon payment is $40 million × 8%= $3.2 million, this interest payment will be the
same $3.2 million per year regardless of EBIT
• After payment for interest rate, firm B’s net earnings = EBIT-$3.2 million
• However, firm B’s total payment = firm B’s net earning + interest payment of $3.2
million = EBIT
THE IRRELEVANCE OF CAPITAL STRUCTURE IN A
FRICTIONLESS ENVIRONMENT
• The intuition behind the M&M capital structure irrelevance is that because firm B offer exactly
the same future cash flows as firm A, the market value of firm B should be $100 million (the
same as firm A)
• For firm B, the market value of the bonds is equal to their $40 million face value (because the
interest payments on firm B’s bonds are assumed to be riskless), hence, the market value of
firm B’s equity should be $60 million ($100 million total firm value less $40 million of debt)
• At this time, the number of shares outstanding of firm B will decide the price per share for
firm B, given the total market value of equity is $60 million
• If the price per share (firm B) = $100 = price per share for firm A -> no arbitrage
• However, if these two prices differ, arbitrage will occur by short selling the amount of stocks in
firm with higher price and simultaneously buying the same amount (%) stocks and bonds of
firm with lower price
THE IRRELEVANCE OF CAPITAL STRUCTURE IN A
FRICTIONLESS ENVIRONMENT
Arbitrage if price per share in firm B is lower than $100 (specifically $60)
THE IRRELEVANCE OF CAPITAL STRUCTURE IN A
FRICTIONLESS ENVIRONMENT
Arbitrage if the price per share in firm B is higher than $100 (specifically $110)
WHY CHOOSING CAPITAL STRUCTURE?

• Help firms reduce some costs or circumvent burdensome regulations (taxes,

bankruptcy costs) (reducing costs in terms of taxes and subsidies)
• Reduce the potential of conflicts of interest among stakeholders (dealing with
conflicts of interest)
• Provide the stakeholders with financial assets not otherwise available to them. And
for the firm, this is an opportunity of expanding financial instruments and earns a
premium for doing that (creating new opportunities for stakeholders)
We will discuss each of the above benefits in the following slides
REDUCING COSTS- TAXES

• Taxes here refer to: corporate income tax (paid by the firms) and personal income
tax (paid by individual shareholder) on cash dividends and realized capital gains
• In many countries, interest expense is deductible in computing a firm’s taxable
income whereas dividends are not. Therefore, the firms will save the cash outflows in
terms of tax if choosing debt financing instead of issuing stocks
• Consider again two firms on the above example (firm A and firm B) (firm A only
issues equity, firm B issue both debt and equity)
REDUCING COSTS- TAXES

• For firm A, the EBIT flow will be divided into 2 components: government (in terms of
taxes) and shareholders (residual)
• For firm B, the EBIT flow will be divided into 3 components: creditors )interest
payments), government (in term of tax) and shareholders (residual)
• Suppose the corporate income tax is 30%, firm B’s total after-tax cash flow to
shareholders and creditors are:
CF (firm B) = CF (for shareholders) + CF (for creditors)
= (1-0.3) (EBIT – interest) + interest
= 0.7 EBIT + 0.3 interest = CF (firm A) + 0.3 interest
REDUCING COSTS- TAXES

• For firm A (firm only issues equity), with EBIT $100 million (tax for government will
be $30 million, and the remaining $70 million is for shareholders). Therefore, we
extract (in the previous slide) that CF (firm A) = 0.7 EBIT (CF for firm A is only for
shareholders)
• For firm B, the value of debt is $40 million, the value of the government’s tax claim is
$18 million ($30 million – PV of interest tax shield (0.3 × $40 million)), hence, the
value of equity is $60 million- $18 million = $42 million
REDUCING COSTS- TAXES

Breakdown of values of claims for firm A and firm B

Claimant Firm A Firm B

Creditors 0 $40 million

Shareholders $70 million $42 million

Government tax $30 million $18 million

authority
Total $100 million $100 million
REDUCING COSTS- SUBSIDIES

• Normally, one or some forms of financing are subject to subsidies, hence, it is

advantageous for firm to choose its capital structure to that direction
• These subsidies are offered based on some special production fields or locations,
and can takes the form of free government guarantee, paying part of the interest on
the debt or to forgo part of the repayment of principal
• Firms operate in some specialized area may beneficial if issuing debt instead of
equity.
REDUCING COSTS- COSTS OF FINANCIAL DISTRESS

• Financial distress refers to a situation when a firm are in a danger of defaulting on

their debt obligations
• In such circumstances, firms usually incur significant costs that reduce the firm’s total
value below what it would be if there were no debt
• These costs may include time and efforts of the firm’s managers to avoid bankruptcy
and fees paid to lawyers
REDUCING COSTS- COSTS OF FINANCIAL DISTRESS

• There exists the tradeoff between taking the costs of financial distress and the tax
savings with high levels of debt financing
• The changes in debt ratio will have an effect on the stock prices
• The goal of a firm’s managers is how they can choose the optimal debt ratio to
maximize the firm’s value. In practice, it is challenge to choose a precise combination
between debt and equity
DEALING WITH CONFLICTS OF INTEREST
INCENTIVE PROBLEMS- FREE CASH FLOW
• The conflict between managers and shareholders: Theoretically, the managers will
act with the target of maximizing the wealth of shareholders. However, sometimes,
due to some reasons (power, prestige,…), managers may choose to invest in an
ineffective projects (incentive problem)
• To solve this problem, issuing debts to repurchase shares (stocks) is an appropriate
way to create value for the shareholders by reducing the amount of free cash flows
available to managers
DEALING WITH CONFLICTS OF INTEREST
CONFLICTS BETWEEN SHAREHOLDERS AND CREDITORS
• Another incentive problem is that: shareholders have little incentive to limit the firm’s
losses in the case of bankruptcy
• Normally, managers will act in the best interest of shareholders to increase
shareholders’ wealth at the expense of the debtholders
• Managers will have more tendency to choose a risky venture even the probability of
that venture is quite small. For them, despite low probability of success, this still be
more valuable for shareholders. In this case, the creditors will bear all the downside
risks (if have) whereas all upside gains (if have) are eligible for shareholders
CREATING NEW OPPORTUNITIES FOR STAKEHOLDERS

• Some financial-service firms can offer for the firms financial instruments that create
value for the shareholders
• Pension plans for employees,
HOW TO EVALUATE LEVERED INVESTMENTS

• In this section, we will take into account a company’s capital structure in evaluating
investment projects
• There are normally three ways of doing that: adjusted present value (APV), flows to
equity (FTE), weighted average cost of capital (WACC). These all methods include the
value of the tax shield in the capital budgeting decision
We will discuss each of the above in the following slides
HOW TO EVALUATE LEVERED INVESTMENTS
INTEREST TAX SHIELD
Example:
Let’s consider the impact of interest expenses on the tax paid by Dorway, Inc, a
grocery store chain. Dorway had EBIT of $1.85 billion, and interest expenses of
$350 million. Given Dorway’s marginal corporate tax rate of 35%, show the
different effect of leverage (with debt) and without leverage (without debt)
HOW TO EVALUATE LEVERED INVESTMENTS
INTEREST TAX SHIELD
Dorway’s income with and without leverage

With leverage Without leverage

EBIT $1850 $1850
Interest expense $350 0
Income before tax $1500 $1850
Taxes (35%) $525 $648
Net income $975 $1202
HOW TO EVALUATE LEVERED INVESTMENTS
INTEREST TAX SHIELD
Total available to all investors

With leverage Without lverage

Interest paid to debt holders $350 0

Income available to equity holders $975 $1202

Total available to all investors $1325 $1202

Dorway’s net income is lower with leverage than it would have been without leverage.
Thus, Dorway’s debt obligations reduced the value of its equity. However, the TOTAL
amount available to all investors is higher with leverage
HOW TO EVALUATE LEVERED INVESTMENTS
INTEREST TAX SHIELD
• Why is the total available to all investors with leverage higher compared to without
leverage?
Answer: due to interest tax shield
Interest tax shield = corporate tax rate × interest payments
= 35% × $350 = $123
Difference in total amount of money to all investors = $1325 - $1202 = $123
HOW TO EVALUATE LEVERED INVESTMENTS
A SPECIFIC EXAMPLE
Example: Looking back again Dorway, Inc, but now this corporation intends to open a
new store with initial investment of $50 million. The expected increase in revenue is
$20 million. To run this store, Dorway bears the maintenance cost of $5 million each
year (Both revenue and cost of maintenance are expected to last forever). Its capital
structure is 20% debt and 80% equity (This debt-equity ratio is kept for this new
investment). The debt is risk-free with an interest rate of 8% per year. If the firm only
issues equity for this investment, the required rate of return is 10%.
HOW TO EVALUATE LEVERED INVESTMENTS
A SPECIFIC EXAMPLE
• Unlevered expected cash flow = (1-0.35) × ($20 million - $5 million) = $9.75
million
• Using the unlevered return as the market discount rate, we have the PV of this new
investment
$9.75 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
PV of unlevered investment = = $97.5 million
10%
• Given the initial investment is $50 million, we compute NPV of this investment (without
leverage)
NPV (without leverage) = PV of unlevered investment – initial investment
= $97.5 - $50 = $47.5 million
HOW TO EVALUATE LEVERED INVESTMENTS
THE ADJUSTED PRESENT VALUE (APV)
• The adjusted present value (APV) method is an alternative valuation method in which
we determine the levered value (VL) of an investment by first calculating its unlevered
value (VU), and then adding the value of the interest tax shield
VL = APV = VU + PV (interest tax shield)
with VU is PV of unlevered investment (just calculated before)
PV of interest tax shield = corporate tax × interest payment
= corporate tax × (proportion of debt × APV)
We have: APV= $97.5 + 0.35 × 0.2 × APV -> APV = $105 million (approximately)
The adjusted net present value = $47.5 + ($105-$97.5) = $55 ($55 = $105-$50)
HOW TO EVALUATE LEVERED INVESTMENTS
THE ADJUSTED PRESENT VALUE (APV)
• To specify two ways of computing the adjusted net present value
Way 1:
Adjusted net PV (adjusted NPV) = Adjusted PV – initial investment
= $105 million - $50 million = $55 million
Way 2:
Adjusted net PV (adjusted NPV) = NPV of unlevered investment + PV of interest tax
shield
= $47.5 + (0.35 × 0.2 × APV ($105))= $55 million
HOW TO EVALUATE LEVERED INVESTMENTS
THE FLOWS TO EQUITY (FTE) METHOD
Step 1: Calculate the incremental expected after tax cash-flows to the firm’s
shareholders (CFS) and the cost of capital (ke)
Step 2: Compute NPV by discounting CFS by the cost of equity capital (ke)
ke = k + (1-t) (k-r)d
In which: ke: cost of equity capital
t: the tax rate
r: the rate of interest rate on the debt, which is assumed to be default risk
d: the market debt-to-equity ratio
HOW TO EVALUATE LEVERED INVESTMENTS
THE FLOWS TO EQUITY (FTE) METHOD
Step 1:
Incremental expected after tax cash-flows to the firm’s shareholders (CFS)
CFS = Unlevered expected cash flow – After-tax interest expense
= $9.75 – (1-t) × r × D = $9.75 – (1-0.35) × 0.08 × D = 9.75 – 0.052D
(D denotes for the increase in Dorway debt outstanding after the project is
undertaken)
The cost of capital (ke)
ke = k + (1-t) (k-r)d = 0.1 + (1-0.35) × (0.1-0.08) (0.02/0.08)= 0.10325
HOW TO EVALUATE LEVERED INVESTMENTS
THE FLOWS TO EQUITY (FTE) METHOD
Step 2: The increase in the present value of equity outstanding (E) is
𝐶𝐹𝑆 9.75−0.052D
E= = (with D=0.25E) (the financing policy is 20% debt, 80%
𝑘𝑒 0.10325
equity)

Solve the above equation, we have E = $83.88, D=21

• The amount of new equity issued to finance this project is $50 (initial investment for
this new project)-$21= $29
• The NPV to the shareholders from undertaking this project is $83.88- $29 = $55
(approximately)
HOW TO EVALUATE LEVERED INVESTMENTS
THE WEIGHTED AVERAGE COST OF CAPITAL (WACC) METHOD
• WACC is a weighted average of the cost of equity capital and the after-tax cost of
debt
• In this method, we estimate the project’s PV by discounting the expected unlevered
after-tax cash flow using a WACC, and then subtract for the initial investment
• The formula for the WACC
HOW TO EVALUATE LEVERED INVESTMENTS
THE WEIGHTED AVERAGE COST OF CAPITAL (WACC) METHOD
• With ke = 0.10325 (calculated from the FTE method)
d=D/E = 0.25, t=35%, r=8%
• We have WACC = 0.093
• The NPV of this project is computed as the expected unlevered after-tax annual cash
flow discounted at the WACC less than $50 (initial investment)
$9.75
NPV = − 50 = $50 (𝑎𝑝𝑝𝑟𝑜𝑥𝑖𝑚𝑎𝑡𝑒𝑙𝑦)
0.093